7/13/2007 @ 4:35PM

Economics 101: Oil Rises On Supply Questions

The price of crude jumped on a multinational report that predicted world oil demand will rise 2.5% in 2008. In the short run, that reflected the temporary closure of a North Sea pipeline. Longer-term, however, questions about supply from Nigeria and Iran mean that the amount of crude available may not keep up with the rising demand.

In late trading in New York, crude oil was quoted at $73.87 a barrel, up $1.37 for the day.

Earlier, North Sea Brent crude oil hit an 11-month high of $77.60, reflecting in part a closed pipeline. North Sea pipelines often are shut for maintenance in the summer months, but this year, the work has coincided with turmoil in Nigeria (See “Nigerian Abduction Drives Oil Prices“) and tensions between the West and Iran.

David Kirsch, manager of the market intelligence service at PFC Energy, said that the wave of kidnappings and the worsening security situation in Nigeria has impacted oil supplies. There was an expectation that in the longer term the shut in volumes in Nigeria would be coming back possibly as soon as the end of this year or even the summer, Kirsch said. We always thought that was an optimistic scenario given the logistical challenges. With the security situation in the Niger Delta its not only unlikely that any shut-in volume is going to be coming back this year, but theres a really good chance well have additional shut-in. A shut-in is when political violence forces the oil service company in a country to stop producing oil.

Bad news for consumers of energy is often good news for its producers. On Wall Street, oil companies gained in late trading with
Hess
in the lead. Hess shares jumped 2.5%, or $1.61, to $66.24, while
ConocoPhillips
shot up 1.9%, or $1.64, to $90.28.
Exxon Mobil
shares gained 0.9%, or 83 cents, to $90.45,
BP
shares rose 0.4%, or 33 cents, to $75.11, and
Chevron
edged up 0.3%, or 27 cents, to $93.57.

Its a very aggressive price trend that wont let up until 2009 and even then its a risk that it will let up, said Kirsch. Were pretty bullish on prices until then.

The International Energy Agency released a report on Friday stating that global oil demand will increase 2.5% in 2008 and repeating a demand that the Organization of Petroleum Exporting Countries increase production to help lower prices. The IEA is an affiliate of the Organization for Economic Cooperation and Development, the Paris-based grouping of industrialized countries.

If you think this is a credible report and that growth in demand next year will be 2.2 million barrels per day then there are of course going to be some concerns over world oil supplies to keep up with that, Kirsch said. But in our view thats a wildly optimistic assumption on growth in demand, and I think it more represents an effort to pressure OPEC than it reflects a real consideration of the factors the IEA has identified in the past. Our prediction for demand is 1.4 million barrels per day – significantly lower than the IEAs for 2008.

Some analysts point out that as the oil supply tightens and the price rises, the demand for crude doesnt subside. Kevin Smith, an analyst at Raymond James, said that the United States economy has gotten used to $70 oil and it no longer scares anyone. Last year and the year before that once we achieved the $70 oil mark we saw an outcry especially in the U.S., Smith said. Were not seeing that right now. To me that signals that the U.S. is okay with $70 oil. Where the question really lies is that if $70 oil isnt high enough to affect consumers’ driving habits, where does the price of oil really need to be before you see a meaningful change in U.S. demand and a change in lifestyle? Its obviously not the $70 level, and we dont think its going to be at the $80 level either.

The falling price of the dollar also continues to put upward pressure on oil prices. As the value of the dollar declines the purchasing power of the OPEC barrel decreases, Kirsch says. In the past two years, the euro has appreciated 12.9% against the dollar

Thats one of the main reasons why OPEC will continue to pursue a very aggressive price strategy, he said. OPEC has not seen a negative impact on the growth of demand with higher oil prices. So theres no drive within OPEC to push for lower oil prices. There are two real negative risks out there: one is a slowdown in the U.S. economy, but even that will have a limited impact. The other one is the potential for worsening trade relations, not only with the U.S. and China, but also with the EU and China, which could really impact on Chinese demand. But thats something we see coming in 2009 at the earliest.You have to show me a recession in the U.S. before I show you a real impact on oil demand, Kirsch said.